Shiller: Let’s sell debt tied to GDP to fix the crisis

FORTUNE – Yale University economist Robert Shiller is perhaps best known for the closely watched S&P Case-Shiller Home Price Index, which offers a month-by-month play on the health of the U.S. housing market. He is an oft-quoted authority on the problems of America’s real estate market and has done extensive research on the complexities of market bubbles.

In his new book, Reforming U.S. Financial Markets: Reflections Before and Beyond Dodd-Frank, Shiller and Randall Kroszner discuss how we could prevent another financial crisis following the near collapse of the U.S. financial system in 2007.

We caught up with Shiller, who spoke last week at the 2011 Simon New York City Conference hosted by Rochester University. Shiller talked about what surprised him most about the housing market, how America could better manage its huge debt problems, as well as his thoughts on the Dodd-Frank financial reform act.

The following is an edited transcript of our chat.

What would you say is the greatest risk to the US economy today?

I am generally optimistic about the longer run. But we could be in for a slow period for years. The U-6 unemployment rate, the more implicit measure of unemployment, is 15.9% — the long-term unemployment rate [those out of work for 27 weeks or more] is 3.8%. It’s never been that high since 1948 when they started collecting those numbers.

So while we’re not in a recession anymore, the economy is just not operating up to potential. If we have another potential recession before we fully recover from the last one, that could be damaging to confidence, just as it was in 1937 and 1938 when there was a recession that began with the 1929 stock market crash.

We’ve had seven quarters of GDP growth that look normal but they haven’t been enough to bring us back to trend. That’s why we still have very high unemployment. There seems to be damaging effects on the national psyche. That’s a mechanism that is not well understood. People are hearing too much news about layoffs of policemen and teachers. There’s a general sense that things aren’t going right. People are also worried about the national debt and the European sovereign debt crisis. All these things are in the air and they inhibit people from spending and creating businesses and inhibit those in the position to hire from hiring.

Speaking of debt, you’ve written extensively on how to better manage U.S. debt through the concept of “Trills,” or issuing U.S. bonds tied to GDP. This has often been associated more with economically stressed countries, such as Argentina and Bosnia. How might this help the risks of America’s burgeoning debt?

The national debt is getting onerous relative to the national income. America’s GDP is not growing normally. We’re facing substantial borrowing costs and it appears we may have to borrow more.

Our new borrowing could be in terms of issuing GDP-linked debt. This way our debt in the future would respond to our economy. If GDP rises then we’re more easily able to pay the debt. But if GDP disappoints then our debt burden is lessened. And our debt to GDP ratio doesn’t shoot up. This makes sense from a risk management perspective.

In some sense, I think people are reacting to these kinds of risks the same way they reacted to home price risks. People thought home prices would never fall, and so they didn’t manage those risks. It’s the same thing with GDP. People say GDP growth never disappoints either but it really can. Japan is an example. If Japan’s GDP had grown as much as it had prior to 1990 they would have phenomenally higher GDP right now. There really is long-term uncertainty about GDP and we should just respect that and manage that risk.

Let’s talk about the housing market. With home prices expected to fall further, it seems a full recovery is still so far away. Other than that, is there anything that surprises you about the market today?

Existing sales have come back up but the market is still languishing. So it’s a little bit of a puzzle. I think the existing sales are dominated by unusual sales – like foreclosure sales and cash only sales, which are investment-type sales. It’s also supported by government intervention. So we’re in a market that is very unusual and not easily forecasted because of all these unusual factors. That’s why I worry about further housing declines. So far, I have been right to worry about them because the rally we saw in home prices after President Obama took office did fizzle and it could fall for years.

When will home prices stabilize?

I don’t know the answer. I think that home prices have fluctuated a lot throughout history and they show trends that go over decades. Even in the U.S. in the first half of the 20th century home prices were generally falling. One thing that I think about when you ask about the stability of home prices is that there seems to be some evidence that our attitude toward housing is changing – that we might not be so stuck on homeownership.

The rental housing market might be more favored. There is also some sense, which I can’t prove, that people are more congenial to urban living than they used to be. The U.S. is famous for its suburbs with expansive front lawns and three cars in every driveway. And then there is another model, which has more public transportation and more urban density and offers some of its own amenities and pleasures. Living in a dense urban environment has more social stimulation – more variety and activities that may be rewarding to people. So the idea that we are going to continue in the suburban movement which began after WWII, I’m not clear at all that we’ll continue along those lines.

Clearly, the U.S. is still healing from the 2007 banking crisis. Aside from the Dodd-Frank Wall Street Reform and Consumer Protection Act, is there anything else we can do to keep us from another financial crisis?

The first thing is that we shouldn’t be too afraid of financial crisis. Finance is all about risk taking – and there are going to be mistakes made.

Countries that have financial crises are also often the richest countries. The Asian Financial Crisis is a good example. The Asian economies have been the best performing economies in the world in the last 20 years. The crisis happened in the late 1990s but Asia recovered quickly from it. And more recently in China we saw a huge stock market boom and then crash after 2007, but it didn’t seem to affect them very much. They rebounded.

We always learn lessons from crisis. One thing you want to do is have a banking system that is resilient to crisis and there’s a long history of trying to make that happen. And I think our banking system is much better now as a result.

Beyond that, we have now much more complicated financial devices in the form of derivatives that are making for better economic outcomes but there are going to be mess-ups along the way.

You’ve expressed how surprised you are that the 140-plus page Dodd-Frank Act only mentions the word “bubble” twice, even though the bust of the housing market bubble played a huge role in the financial crisis. Do you think the legislation protects us from the risks of derivatives?

I think that Dodd-Frank is an inspiring response in the sense that a democratic society has done something constructive but I don’t think it’s the end of the line. I think much more needs to be done. Fortunately, the Dodd-Frank calls for a lot of studies for what to do and I hope that some of these studies would be aggressive in what they recommend.

In your new book, you underscore the broader importance of democratizing and humanizing finance. This goes beyond financial reform’s legislative and regulatory fixes. Can you talk about these concepts?

I think people are what matters. Corporations don’t matter, except for the fact that they are owned by people and they serve people.

In terms of democratizing finance, I think people need to get better information and advice so that they know what they’re doing and they can be active participants in a financial community. It used to be that the feudal lord owned everything. Democratization is a long trend that will continue.

And humanizing finance means recognizing the human element of producing bubbles and booms. They’re a social psychological phenomena, and we have to draw on all the social sciences to try to understand them. The economics profession over the last half century has become more involved in abstract mathematics and econometrics and sometimes that approach leads to a dismissal of causes that are really fundamental.

The idea that politics plays a role in markets is just not in most of the models. Part of the reason we had this crisis is that we trusted these econometric models too much. The models were saying clear sailing ahead and so no one took any action. It wasn’t represented in the models.

I’m hopeful that we will move to a better understanding of these markets with the experience of this crisis.